The Market Price of Risk and the Equity Premium

Tim W. Cogley and Thomas Sargent

No 55, Working Papers from University of California, Davis, Department of Economics

Abstract: Friedman and Schwartz hypothesized that the Great Depression created ex-aggerated fears of economic instability. We quantify their idea by using arobustness calculation to shatter a representative consumer?s initial confidencein the parameters of a two-state Markov chain that truly governs consump-tion growth. The assumption that the consumption data come from the trueMarkov chain and the consumer?s use of Bayes? law cause that initial pessimismto wear off. But so long as it persists, the representative consumer?s pessimismcontributes a volatile multiplicative component to the stochastic discount factorthat would be measured by a rational expectation econometrician. We studyhow this component affects asset prices. We find settings of our parametersthat make pessimism wear off slowly enough to allow our model to generatesubstantial values for the market price of risk and the equity premium.

Keywords: market; risk; equity premium; asset pricing (search for similar items in EconPapers)
JEL-codes: D83 D84 G12 (search for similar items in EconPapers)
Pages: 32
Date: 2005-02-28
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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